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ME - End Term Answer Key

The document contains an answer key for a microeconomics end term exam. It includes answers to 6 questions related to topics like social welfare maximization, insurance decisions under risk, duopoly market equilibrium, Nash equilibrium strategies, profit maximization for banks setting interest rates, and impact of externalities and taxes on market equilibrium. The answers provide numerical values and equilibrium outcomes for the various economic scenarios described in the questions.

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Shubham Agarwal
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165 views7 pages

ME - End Term Answer Key

The document contains an answer key for a microeconomics end term exam. It includes answers to 6 questions related to topics like social welfare maximization, insurance decisions under risk, duopoly market equilibrium, Nash equilibrium strategies, profit maximization for banks setting interest rates, and impact of externalities and taxes on market equilibrium. The answers provide numerical values and equilibrium outcomes for the various economic scenarios described in the questions.

Uploaded by

Shubham Agarwal
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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MICROECONOMICS

END TERM EXAM


ANSWER KEY

Question 1. Delhiites rely on the Yamuna for a large share of their drinking water. As such they
like the water to be clean and free of toxins and incur significant costs of purification if the river
is polluted. Factories upstream produce plastics and chemicals and often use the Yamuna as a
giant drain for their effluents. The effluent level is directly proportionate to the production level
of a factory. Since Dilliwalas suffer as a consequence, there is considerable litigation between
the upstream factories and the downstream cities about the level of effluents. Consider the
following costs and benefits of effluents.

Purification costs to Production benefit to


Tons of upstream
Delhi upstream factories
effluents
(in Rs. Crores) (in Rs. Crores)
0 0 0
1000 24 60
2000 52 108
3000 96 148
4000 144 180
5000 204 204

(a) What level of upstream effluents maximize social welfare? [2 points]


(b) With bargaining, if city residents have a right to clean water, what will be the level of
effluents? [2 points]
(c) What is the minimum amount the factories have to pay to the city? [2 points]
(d) Before the enactment of clean water laws, factories had the right to dump waste in rivers. If
back then residents wanted cleaner water and engaged in bargaining with the factories what
would be the level of effluents? What is the minimum amount the city would have to pay to
the factories? [2 + 2 points]
a. The level of upstream effluents that maximize social welfare is 2000 tons.

b. The level of upstream effluents will be 2000 tons.

c. The minimum amount the factories have to pay to the city is Rs. 52 crores.

d. The level of upstream effluents would have been 2000 tons.

The minimum amount the city would have to pay to the factories is Rs. 96 crores.
Question 2. Khera Jewelers has Rs. 64 lakhs worth of valuables stored inside, and (accordingly
to a security assessment) faces a 20% chance of theft next year. Suppose a theft reduces the value
of Khera Jewelers’ assets to Rs. 16 lakhs. The Vastrapur Insurance Company (VIC) offers theft
insurance with a promise of full reimbursement of damages if Khera Jewelers pays an up-front
insurance premium. The owner of Khera Jewelers is risk-averse with a utility for wealth given by
1
U(wealth) = 𝑤𝑒𝑎𝑙𝑡ℎ2 , where wealth is in lakhs (so for example, U(Rs. 4 lakhs) = 2).

(a) Without insurance, what is the expected value of Khera Jewelers’ holdings? [3 points]
(b) Without insurance, what is the certainty equivalent of Khera Jewelers’ holdings? [3 points]
(c) What is the maximum annual premium that VIC can charge so that Khera Jewelers purchases
the insurance policy? [4 points]

a. The expected value of Khera Jewelers’ holdings is Rs. 54.4 lakh.

b. The certainty equivalent of Khera Jewelers’ holdings is Rs. 51.84 lakh.

c. The maximum annual premium that VIC can charge is Rs. 2.56 lakh.
Question 3. Consider a duopoly with two firms, Apple and Banana, that produce wearable
phones (previously, consumers had to carry phones in their pockets). Apple faces the following
demand function for its phone.

qA = 100 – 2pA + pB

where qA is the quantity of Apple’s phone that consumers demand, pA is the price at which Apple
sells its phone, and pB is the price at which Banana sells its phone. Assume that Apple produces
phones at a constant marginal cost cA = 10.

Similarly, Banana faces the following demand function for its phone

qB = 100 – 2 pB + pA

where qB is the quantity produced by Banana. Assume that Banana produces phones at a constant
marginal cost cB = 15, and that neither firm has any fixed costs.

(a) Determine the reaction function associated with each firm in this market if firms compete
primarily by simultaneously deciding price. [2 + 2 points]

(b) Determine the equilibrium price for Apple and the equilibrium price for Banana. [2 + 2
points]

(c) Which firm has higher profits? [2 points]

a. Reaction function for Apple pA = (pB+120)/4

Reaction function for Banana pB = (pA+130)/4

b. Equilibrium price for Apple is 40.67

Equilibrium price for Banana is 42.67

c. The firm with the higher profits is Apple


Question 4. Two toothpaste brands – Fresh and Splash are competing to develop a new
toothpaste. Suppose Fresh is ahead in the development process, and Splash is deciding whether
to enter the competition. If Splash stays out, it earns zero profit while Fresh enjoys a monopoly
and earns a profit of Rs. 50 crores. If Splash decides to enter and develop a rival toothpaste, then
Fresh has to decide whether to accommodate it, wage a price war, or develop an improved dental
care product. In the event of accommodation, each firm will make a profit of Rs. 15 crores. In the
event of a price war, each firm will lose Rs. 5 crores. If Fresh develops a new toothpaste, it will
earn Rs. 20 crores while Splash earns Rs. 5 crores. Solve for the Nash equilibrium strategies and
outcomes. [3 + 3 + 2 + 2 points]

The Nash equilibrium strategy for Fresh is Develop a new product

The Nash equilibrium strategy for Splash is Enter the market

The Nash equilibrium earnings for Fresh is Rs. 20 crores

The Nash equilibrium earnings for Splash is Rs. 5 crores


Question 5. Two banks - Allied Bank and Swarna Capital – are deciding the interest rates to
offer on fixed term deposits. Each calculates its expected profits as a function of the interest rate
it offers, and its competitor offers. Specifically, the following table shows profits for each bank
(in Rs. crores).

Allied Bank

4% 4.5% 5%

4% 48, 32 32, 64 32, 32


Swarna
Capital
5% 48, 48 16, 32 48, 16

Determine interest rates in this market if Swarna Capital decides rates first and Allied decides
second. [5 + 5 points]

Swarna Capital will charge 5%

Allied Bank will charge 4%


Question 6. The demand for cigarettes in Ahmedabad is given by 20QD =300 - P, where price
(P) is measured in rupees per packets of cigarette and quantity ( Q ) is measured in thousands of
packets. The aggregate supply curve of cigarettes is known as P = 50 + 5QS .
(a) Determine the equilibrium quantity of cigarettes consumed in this market. [2 points]
(b) A researcher from the Centre for Management of Health Services at IIMA reports a strong
link between cigarettes consumption and lung cancer among children due to passive
smoking, implying that consumption of cigarettes causes a negative externality. The
researcher has calculated that the cost of the externality is ₹50 per packet of cigarettes. As a
result, the municipality has recommended imposing a tax of ₹50 per packet. Determine the
new equilibrium quantity of cigarettes consumed in this market, the price paid by buyers, the
price received by sellers, and the tax revenue received by the city. [2 + 2 + 2 +2 points]

a. Equilibrium quantity of cigarettes is 10 thousands of packets

b. New equilibrium quantity of cigarettes 8 thousands of packets

Price paid by buyers is Rs. 140 per packet

Price received by sellers is Rs. 90 per packet

Tax revenue received by the city is Rs. 400 (thousand)

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